Rensselaer Economist Calculates Degree to Which Government Borrowing Can Dampen Effects of Stimulus Spending in a Downturn

March 17, 2011

Rensselaer Economist Calculates Degree to Which Government Borrowing Can Dampen Effects of Stimulus Spending in a Downturn

The effect of government spending to spur the economy is
undermined when government finances the stimulus by borrowing
money, according to a new mathematical model developed by a
Rensselaer Polytechnic Institute professor.

Economist and Clinical Professor of Economics John Heim said
the new model pinpoints the negative “crowd out” effect of
government borrowing on private investment, an effect
overlooked by John Maynard Keynes, upon whose 20th
century work current policies of deficit spending in times of
recession are based.

Heim’s work calculates that the effect of each dollar of
government stimulus - whether tax cuts or increased government
spending - financed by borrowing is eroded by a factor of
at least 100% due to crowd out effects. In other words, Heim
said, government “stimulus” financed by borrowing has a net
negative effect on the economy.

The findings, which are detailed in the Journal of the
Academy of Business and Economics, sound a cautionary note to
leaders grappling with economic downturns.

“What this means for public policy is that you should expect
that a stimulus will not have the effect that politicians
expect it to have,” Heim said. “In a recession, everyone falls
back on a Keynesian stimulus. Keynes never seriously addressed
the ‘crowd out’ factor.”

Heim specializes in research that converts statistics into
mathematical models depicting the economy – a field known as
econometrics.

Crowd out, Heim said, turned out to be an excellent subject
for research.

Crowd out begins with the point that the pool of money
available to be borrowed – to fuel private investment and
consumption – is limited.

“Businesses and consumers buy much of what they buy with
borrowed money - consumers using credit card borrowing, car
loans; businesses using bank loans for new factory equipment,
etc.,” Heim said. “If government borrows part of the money
available, it reduces what’s left for businesses and consumers
to borrow.”

If the government borrows massive amounts of money to
finance and economic stimulus, the government absorbs much of
the pool. In doing so, the government limits – or “crowds out”
– private investment and consumption fueled by borrowing. By
hindering private investment and consumption, the effect of the
money spent in the stimulus is dampened.

“Most of the people who have addressed this issue in the
years since 1930 were people in the business press, not the
scientific press,” Heim said. “There’s been a lot of deductive
work done, but there ought to be more scientific work done than
there really is.”

Heim’s work builds on current models for Gross Domestic
Product (GDP) – a measure of the nation’s production in a given
year. Although the basic formula is very simple – GDP =
Consumption + Investment + Government spending + Net exports–
economists have deepened the formula over decades of research
to account for the complex composition of each of these
variables and the relationships between them.

For example, economists have calculated that consumption –
which drives GDP – is in turn determined by disposable income,
wealth, interest rates and the exchange rate, and that a change
in any of those variables changes consumption.

Heim[‘s] used statistics from the Economic Report of the
President, an annual report generated by the President’s
Council of Economic Advisors, to test whether the current model
works for the best possible data on the United States
economy.

When he first plugged numbers from the report into current
mathematical equations for GDP in the summer of 2003, he came
up with a result he knew to be impossible.

“I came up with a positive relationship between taxes
and GDP testing standard Keynesian models– when taxes went up,
GDP went up. I thought I must be doing something wrong and I
spent a whole summer trying to calculate properly,” Heim said.
“It took three years to figure out that it was because of crowd
out.”

Heim used multiple regression analysis – a technique used by
other econometricians, mathematicians and engineers – to test
the relationships between the components of GDP.

Only when he added a crowd out variable to standard
Keynesian models, and retested them did the statistical results
explain the positive coefficient on taxes.

“The test results obtained represent the average way over a
40 years period that the change in deficit affected the
consumption and investment components of the GDP,” Heim
said.

The finding fits patterns of GDP in times of heavy
government borrowing, Heim said. As GDP increases,
investment should increase. But after 1982, Heim said,
investment fell far below predicted figures as the U.S.
government started running large deficits. In 1998, it rose
considerably above predicted figures as the U.S. government
started running surpluses.

“Why was that? There was a huge tax cut in 1982 in the U.S.,
roughly speaking everyone in the U.S. saw their tax bills
decline 25%. Unfortunately spending wasn’t cut so the budget
ballooned enormously in the ‘80s and to finance the budget what
they did was borrow money,” Heim said. “That cut down
markedly on the amount of money businesses could borrow for
investment, and investment dropped, just as crowd out theory
would lead us to believe.”

In 1998, for the first time since 1967, the United States
government experienced a budget surplus, allowing it to cease
borrowing and retire outstanding debt.

“From ‘98 to 2000, sure enough, businesses could borrow more
money than had been available prior to 98, invested more than
one would expect from the historic trend.

The full text of Heim’s paper – “Do Government Deficits
Crowd out Consumer Spending and Investment” – is available from
the Working Paper section of the Rensselaer Department of
Economics. Heim’s paper is marked working paper #1005. A link
to the site is as follows: